Would Microsoft Systems MSFT want  to buy Verinet VRNT? Probably not at this price
Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com This week’s Danger Zone pick has seen margins contract as early success brought more competition. To try and offset competitors taking market share, the firm made numerous shareholder value-destroying acquisitions. Nevertheless, the stock is up 28% over the past year and is pricing in aggressively optimistic improvements in revenue growth and profit margins. Verint Systems (VRNT: $44/share) is in the Danger Zone this week.

Profits Are Headed In The Wrong Direction

Verint Systems’ after-tax profit (NOPAT) declined from $111 million in 2014 to $34 million in 2017, or -33% compounded annually. Revenue has grown 5% compounded annually over the same time, per Figure 1. Verint’s NOPAT margin has also fallen from 12% in 2014 to 3% in 2017.

Figure 1: Verint Systems NOPAT Decline

MSFT Microsoft Verint Systems VRNT

Sources: New Constructs, LLC and company filings

Verint has burned through $445 million (16% of market cap) in free cash flow over the past five years. It burned $104 million (4% of market cap) in 2017. The company’s $311 million in cash currently on the books can support the 2017 cash burn rate for less than three years. Verint’s fundamentals are trending in the wrong direction.

Acquisitions Have Been A Poor Use of Capital

Management continually touts acquisitions as “earnings accretive” or “shareholder friendly” based on the high low fallacy. More rigorous research reveals these acquisitions to be poor allocations of capital and harmful to the economics of the business.

Since 2014, Verint has spent upwards of $765 million (28% of market cap) to acquire companies including KANA Software, UTX Technologies, and Contact Solutions. While these acquisitions helped grow revenue, they did little to grow profits and earn a quality return on invested capital (ROIC). Per Figure 2, VRNT’s ROIC was 10% in 2014 and has fallen to a bottom-quintile 2%. Verint’s acquisitions have not been as accretive to equity owners as the company reported.

Figure 2: Acquisitions Lead to Declining ROIC

Verint Systems

Verint Systems VRNT

Sources: New Constructs, LLC and company filings

Executive Compensation Plan Creates Corporate Governance Risk

Verint’s executive compensation incentives are not aligned with shareholders’ interests. Misaligned compensation plans can lead to poor capital allocation decisions as outlined in Figure 2 because they reward executives for destroying shareholder value.

Verint’s executives are eligible for base salaries, cash incentives, and long-term equity awards. Bonus payouts are based on performance goals established by the compensation committee. The goals include revenue, operating income, operating cash flow, and “management business objectives.” These metrics fail to measure shareholder value creation.

Long-term equity awards are given in a mix of time based and performance based restricted stock units. Restricted stock units are granted based on an equal weighting of revenue, EBITDA, and total shareholder return goals. As shown earlier, acquisitions can grow revenue while profits deteriorate. Furthermore, investors should be wary of heavy use of stock price as an incentive. Decisions can be made to maximize stock price in the short-term while the long-term best interests of the business go ignored.

As we’ve shown in numerous case studies, ROIC, not EBITDA, revenue, or management business objectives, is the primary driver of shareholder value creation. Without major changes to this compensation plan (e.g. emphasizing ROIC), investors should expect further value destruction.

Non-GAAP Metrics Attempt to Hide Losses

Verint uses non-GAAP metrics such as non-GAAP revenue, non-GAAP operating income, adjusted EBITDA, and non-GAAP net income to paint the business in a more positive light. Below are some of the items Verint has removed when calculating its non-GAAP metrics:

  1. Stock based compensation expense
  2. Acquisition expenses
  3. Restructuring expenses
  4. Amortization of acquired technology
  5. Impairment charges

These adjustments have a large impact on the disparity between GAAP net income, non-GAAP net income, and economic earnings. In 2016 and 2017, Verint removed nearly $65 million (6% of revenue) and $66 million (6% of revenue), respectively, in expenses related to stock-based compensation to calculate non-GAAP net income. Additionally, the firm removed $29 million (3% of revenue) in restructuring and acquisition expenses in 2017. When added with the other adjustments, Verint reported 2017 non-GAAP net income of $159 million. Per Figure 3, GAAP net income was -$29 million and economic earnings were -$87 million in 2017.

Figure 3: Disconnect Between Non-GAAP & Economic Earnings

Verint Systems
Verint Systems

Sources: New Constructs, LLC and company filings

Lagging Profitability Across Multiple Markets

Verint’s business straddles two separate markets, each ripe with competition. Its Customer Engagement segment (66% of 2017 revenue) provides customer experience/behavior analysis, workforce optimization, and employee engagement services. Its Cyber Intelligence segment (34% of 2017 revenue) provides data mining, threat protection systems, and more. These broad ranging services pit Verint’s business against the likes of Oracle (ORCL), Microsoft (MSFT), International Business Machines (IBM, Elbit Systems (ESLT), Pegasystems (PEGA), and salesforce.com (CRM), among others.

Per Figure 4, Verint Systems’ ROIC and NOPAT margin fall well below its competition. In fact, the only firms with lower margins are prior Danger Zone picks salesforce.com and FireEye (FEYE), the latter of which is down 12% while the S&P is up 18% since the original Danger Zone report. Success in the intelligence analytics industries is ultimately dependent upon the functionality of the product offered and price. The firms with the highest profitability, such as Oracle or even Nice Systems, have greater flexibility to invest in product enhancements or undercut competitors’ pricing if necessary. Firms with lower profitability, such as Verint Systems, face margin pressures and have less ability to invest in product innovation.

Figure 4: Verint Systems’ Lagging Profitability

Verint Systems
Verint Systems

Sources: New Constructs, LLC and company filings 

Bulls Case Ignores Verint’s Struggles Since Entering Customer Engagement

Verint Systems  bulls will point to the growing intelligence/data analytics market, increased cyber threats, and changing customer engagement preferences as reasons to buy into the firm’s potential. However, the bulls’ beliefs ignore the issues Verint has faced since its acquisition of KANA Software and the firm’s inability to improve margins as it has scaled.

Verint Systems aimed to create an end-to-end product suite for workforce optimization, enterprise processes, and customer interaction with its acquisition of KANA Software. This acquisition greatly improved its addressable market, but also significantly increased competition. At the same time, it did not provide Verint Systems a competitive advantage, as the firm has been forced to continually increase spending to remain competitive. Per Figure 5, Verint’s cost of revenues, research & development, and sales, general, and administrative costs have grown 11%, 11%, and 8% compounded annually respectively since 2014. Over the same time, revenue has grown just 5% compounded annually.

Figure 5: Verint’s Expenses Growing Quicker Than Revenue

Sources: New Constructs, LLC and company filings 

These growing costs, particularly R&D, are critical to Verint’s success. The firm recognizes it must consistently develop new products that address changes in technology and customer

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